Portillo's: Activist Involvement Should Improve Expansion Efforts

seekingalpha09-05

Portillo’s stock has performed poorly after the 2021 IPO as the significant, healthily performing expansion efforts have been capital heavy, causing high debt and dilution.Activist investor firm ...

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Joe Hendrickson Founded in 1963, Portillo’s Inc. (NASDAQ:PTLO) operates restaurants that serve Chicago-style hot dogs, as well as grilled burgers, beef sandwiches, and other food items. The company has continued expanding its restaurant chain nationwide across the United States, showing constant good revenue growth. The company’s post-IPO stock performance after the 2021 IPO has been poor, as the stock has lost over two thirds of the value from its initial trading. After the stock has had such a weak run amid Portillo’s continued nationwide expansion, activist firm Engaged Capital has now taken interest in the restaurant chain to turn the expansion strategy around. Stock Chart From IPO (Seeking Alpha) Portillo’s Is Growing Ambitiously, But With Too Heavy Capital Investments After the IPO, contrary to what the stock price suggests, Portillo’s has continued expanding its restaurant footprint with healthy operating income. After the company had a total of 69 locations at the end of 2021, primarily located in Illinois, the company has expanded into a total of 85 locations at the end of Q2 2024 with new expansion being primarily outside of the Illinois market where Portillo’s was founded. Revenues have grown at a CAGR of 8.9% from 2019 to the Q2 2024 trailing revenues of $702.4 million, with healthy same-restaurant sales growth. The growth has been achieved with mostly healthy profitability, as Portillo’s current operating margin trails at 8.1% with operating income of $56.6 million. The margin is still below the 2019 operating margin of 10.1% primarily due to higher pre-opening costs at a trailing $9.9 million, but has expanded healthily from Covid-time margins with slowing inflation and normalized traffic. The recently reported Q2 comparable sales growth came in at just a weak -0.6%, but seems to be related more to weak industry traffic instead of Portillo’s-specific issues. Author's Calculation Using TIKR Data The achieved growth is only the start of Portillo’s ambitious targets. The company targets 12-15% annual unit growth with 10+ new units being developed in 2024 alone, totaling for a total mid-teens annual revenue growth target when combined with the slow same-restaurant sales growth target – with only 85 locations outstanding, Portillo’s is still quite a small chain with exposure being mostly in Illinois, enabling it for a long growth runway.   PRTO Q2 Investor Presentation While Portillo’s growth has been good so far, the stock hasn’t appreciated with the restaurant network expansion. The reason may rely on Portillo’s capital heavy expansion where the company develops its own real estate – capital expenditures reached $87.9 million in 2023 with a similar capital expenditure guidance for 2024, pushing cash flows negative despite healthy earnings. The heavy real estate development has also weakened capital efficiency considerably into a current low 6.9% return on equity, not making the current expansion very accretive to investors. The heavy expansion strategy has also caused dilution and forced Portillo’s to take on significant debt, with a current $305.1 million of total interest bearing debt standing on the company’s balance sheet. Weighted outstanding shares have increased from 35.8 million in 2021 into currently trailing 57.5 million. With the restaurant industry’s quite cyclical earnings nature and immense competition, the current amount of debt is unhealthy, although I do believe that the current real estate portfolio can still support such debt with potential sale-and-leasebacks. Engaged Capital Takes a Stake in Portillo’s Recently, activist firm Engaged Capital was announced to have taken a stake in Portillo’s, sending the stock up moderately. The move from the activist investor firm could be significant for Portillo’s – typical for activist investors, Engaged Capital’s strategy revolves around maintaining a good ownership of a company (currently nearly 10% of Portillo’s), and pushing for operational changes to ultimately drive shareholder value from a long-term owner's perspective. The firm is also known for its successful turnaround efforts with Shake Shack (SHAK). While Engaged Capital isn’t pursuing for leadership changes, CNBC’s report on the matter showcases some of the operational changes that Engaged Capital has identified with Portillo’s. Most notably, the activist investment firm is pushing for a different expansion investment strategy - rather than spending immense amounts of capital on developing company-owned real estate, showcased by Portillo’s current $85-88 million capital expenditure guidance for 2024, Engaged Capital is pushing for more agile expansion. Engaged Capital believes that combined, lighter real estate investments and smaller new location sizes could ultimately double new restaurants’ cash-on-cash returns from 25% to 50%. With the lighter expansion model, Engaged Capital is pushing for accelerated nationwide expansion. I believe that Engaged Capital’s involvement is very good for Portillo’s. While I have been bearish on Shake Shack due to its incredibly high valuation, the activist firm’s involvement has driven improvements in the company’s earnings. The proposed, smaller-location expansion strategy for Portillo’s also seems to make sense for a casual dining hot dog & sandwich restaurant chain, and as capital expenditures have ballooned due to expensive real estate development. A lighter expansion strategy could also put an end to Portillo’s quite high prior dilution. Portillo’s management's and board’s reception of the proposed turnaround is still unknown, but as per CNBC’s sources, Engaged Capital’s and Portillo’s management’s conversations have so far been constructive – I believe that Engaged Capital’s engagement should put forward at least some changes. Engaged Capital believes that with its suggestions implemented, the stock could be worth at least 100% more than it is currently. PRTO Stock Valuation I constructed a discounted cash flow [DCF] model for Portillo’s to estimate a fair value for the stock. In the model, I account for changes in the company’s expansion strategy as suggested by Engaged Capital. For revenue growth, I estimate a CAGR of 10.2% from 2023 to 2033 and 3.0% perpetual growth afterwards, still trailing from Portillo’s own long-term target level as I believe that some conservatism is due. The revenue estimates could still well turn out to be too low, especially if Engaged Capital’s accelerated, agile growth strategy is implemented well. I estimate the EBIT margin to slowly climb back into 10.0%, near the company’s pre-pandemic 10.1% level. The margin should, in my opinion, expand well through better mid-term traffic with an industry recovery from an eventually better consumer sentiment, as well as great operating leverage from larger operations that allow for more efficient marketing, sourcing, and corporate costs. Also, the slowing growth should push down Portillo’s currently considerably high pre-opening cost level, likely allowing for the 10.0% estimate in the long term despite less owned real estate development in the estimates. Through the company’s historically great working capital management, I believe that Portillo’s has the chance for a good cash flow conversion even amid aggressive expansion, if the company moves to the more agile expansion strategy that Engaged Capital suggests – the DCF model includes the assumption that Portillo’s moves more onto rented properties in its growth strategy in upcoming years, slowly improving the conversion. DCF Model (Author's Calculation) The estimates put Portillo’s fair value estimate at $15.73, 31% above the stock price at the time of writing – I believe that if Engaged Capital’s suggestions go through, the stock could finally have seen a bottom and could be an attractive investment opportunity. The revenue estimates could also turn out to be too conservative in the DCF model if Portillo’s growth strategy picks up better than expected. CAPM A weighted average cost of capital of 8.36% is used in the DCF model. The used WACC is derived from a capital asset pricing model:   CAPM (Author's Calculation) In Q2, Portillo’s had $6.6 million in interest expenses, making the company’s interest rate 8.65% with the current amount of interest-bearing debt. I estimate quite a high 40% long-term debt-to-equity, as Portillo’s leverages quite a high amount of debt. To estimate the cost of equity, I use the 10-year bond yield of 3.82% as the risk-free rate. The equity risk premium of 4.11% is Professor Aswath Damodaran’s estimate for the US, updated in July. I use Aswath Damodaran’s restaurant industry beta estimate of 1.19 for Portillo’s. With a liquidity premium of 0.4%, the cost of equity stands at 9.11% and the WACC at 8.36%. Takeaway  Portillo’s has grown its restaurant footprint at a good pace, but the stock hasn’t appreciated with the chain’s growth, as heavy real estate development investments and its required financing have made the expansion weakly accretive to investors with a poor return on invested capital. Engaged Capital, an activist investor firm, has now taken notice of the underperforming growth strategy and is pushing for changes in the strategy into more agile expansion, being a great factor in my opinion. With less real estate development and smaller unit sizes, the restaurant chain’s underlying value could be surfaced better, potentially making the stock an attractive investment at the currently low stock price. As such, I initiate Portillo’s with a Buy rating.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.26.4","shortVersion":"4.26.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2465565401"}